Capital Structure & Cost of Capital. Introduction Capital budgeting affects the firm’s well-being Discount rate is based on the risk of the cash flows.

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Presentation on theme: "Capital Structure & Cost of Capital. Introduction Capital budgeting affects the firm’s well-being Discount rate is based on the risk of the cash flows."— Presentation transcript:

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Capital Structure & Cost of Capital

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Introduction Capital budgeting affects the firm’s well-being Discount rate is based on the risk of the cash flows Discount rate is based on the risk of the cash flows Errors in capital budgeting can be serious   Need to compensate investors for financing   Project Expect Return   Project Cash Flows

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Break-Even EBIT EBIT where EPS is the same under both the current and proposed capital structures EBIT where EPS is the same under both the current and proposed capital structures If EBIT > break-even point If EBIT > break-even point then leverage is beneficial to our stockholders If EBIT < break-even point If EBIT < break-even point then leverage is detrimental to our stockholders

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Ex: Break-Even EBIT

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Cost of Equity Varies If the level of debt increases, the riskiness of the firm increases. Increases the cost of debt. However, the riskiness of the firm’s equity also increases, resulting in a higher r e.

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Risks Business risk: Uncertainty in future EBIT Depends on business factors such as competition, industry trends, etc. Level of systematic risk in cash flows Financial risk: Extra risk to stockholders resulting from leverage Depends on the amount of leverage NOT the same as default risk

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Taxes + Bankruptcy Probability of bankruptcy increases with debt Probability of bankruptcy increases with debt Increases the expected bankruptcy costs Increases the expected bankruptcy costs Eventually, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost Eventually, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost At this point, the value of the firm will start to decrease and the WACC will start to increase At this point, the value of the firm will start to decrease and the WACC will start to increase

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Project WACC  Using a general industry or company cost of capital will lead to bad decisions.

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Using Firm WACC Only for projects that mirror the overall firm risk Only for projects that mirror the overall firm risk Only be used if the new financing has the same proportion of debt, preferred, and equity Only be used if the new financing has the same proportion of debt, preferred, and equity Otherwise, use the project cost of capital Otherwise, use the project cost of capital

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Pure Play Find several publicly traded companies exclusively in project’s business Find several publicly traded companies exclusively in project’s business Use pure play betas to proxy for project’s beta Use pure play betas to proxy for project’s beta May be difficult to find such companies May be difficult to find such companies Note if the pure play is levered Note if the pure play is levered Betas are non-stationary over time Cross-sectional variation of betas, even within the same industry